Forex Walkthrough

Level 4 Charts - Bollinger Bands®

Bollinger Bands® are a technical chart indicator popular among traders across several financial markets. On a chart, Bollinger Bands® are two "bands" that sandwich the market price. Many traders use them primarily to determine overbought and oversold levels. One common strategy is to sell when the price touches the upper Bollinger Band® and buy when it hits the lower Bollinger Band®. This technique generally works well in markets that bounce around in a consistent range, also called range-bound markets. In this type of market, the price bounces off the Bollinger Bands® like a ball bouncing between two walls.




Figure 1

Even though prices may sometimes bounce between Bollinger Bands®, the bands should not be viewed as signals to buy or sell, but rather as a "tag". As John Bollinger was first to acknowledge, "tags of the bands are just that - tags, not signals. A tag of the upper Bollinger Band® is not by itself a sell signal. A tag of the lower Bollinger Band® is not by itself a buy signal." Price often can and does "walk the band". In those instances, traders who keep trying to sell when the upper band is hit or buying when the lower band is hit will face an excruciating series of stop-outs or worse, an ever-increasing floating loss as price moves further and further away from the original entry point. Take a look at the example below of a price walking the band. If a trader had sold the first time the upper Bollinger Band® was tagged, he would have been deep in the red.



Figure 2

Perhaps a better way to trade with Bollinger Bands® is to use them to gauge trends.

Using Bollinger Bands® to Indentify a Trend
One common cliché in trading is that prices range 80% of the time. There is a good deal of truth to this statement since markets mostly consolidate as bulls and bears battle for supremacy. Market trends are rare, which is why trading them is not nearly as easy as one might think. Looking at price this way we can then define trend as a deviation from the norm (range).



At the core, Bollinger Bands® measure and depict the deviation or volatility of the price. This is the reason why they can be very helpful in identifying a trend. Using two sets of Bollinger Bands® - one generated using the parameter of "1 standard deviation" and the other using the typical setting of "2 standard deviation" - can help us look at price in a different way.

In the chart below we see that whenever the price channels between the two upper Bollinger Bands® (+1 SD and +2 SD away from mean) the trend is up. Therefore, we can define the area between those two bands as the "buy zone". Conversely, if price channels within the two lower Bollinger Bands® (–1 SD and –2 SD), then it is in the "sell zone". Finally, if price wanders around between +1 SD band and –1 SD band, it is basically in a neutral area, and we can say that it's in "no man's land".

Another great advantage of Bollinger Bands® is that they adjust dynamically as volatility increases and decreases. As a result, the Bollinger Bands® automatically expand and contract in sync with price action, creating an accurate trending envelope.




Figure 3

Conclusion
As one the most popular trading indicators, Bollinger Bands® have become a crucial tool to many technical analysts. By improving their functionality through the use of two sets of Bollinger Bands®, traders can achieve a greater level of analytical sophistication using this simple and elegant tool for trending. There are also numerous different ways to set up the Bollinger Band® channels; the method we described here is one of the most common ways. While Bollinger Bands® can help identify a trend, in the next section we'll look at the MACD indicator which can be used to gauge the strength of a trend. (To look at other types of bands and channels, take a look at Capture Profits Using Bands And Channels.)


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